Credit Rating System
Credit Rating System denotes a set of tools and methodologies that assist with the creation of Credit Risk metrics, which in turn assist with the Risk Management of credit portfolios. The objective or a rating system is to rank borrowers systematically with meaningful credit risk quality differentiation
A credit rating system will include a number of components depending on the complexity and scope of its application. For example
- A Credit Rating Scale, a limited set of states to which all exposures are classified
- Specific rating definitions, processes and criteria for assigning exposures to grades, collectively denoted as the Credit Rating Philosophy
- For regulated firms the credit rating system will in particular provide Risk Parameters:
Institutions must have specific definitions, processes and criteria for assigning exposures to grades or pools. The grade and pool definitions must be sufficiently detailed.
Issues and Challenges
- It is very common that that rating system is fundamentally based on the probability of default of borrowers, but credit loss rating systems are also possible. Comparisons between such different design systems can be fraught with difficulties (additional assumptions and Credit Rating Philosophy differences)
- The construction of rating systems enables significant differences in how they respond to the fluctuations of economic activity. This is know as the Point-in-time versus Through-the-cycle difference.
- While many aspects of credit rating systems are algorithmic / automated, human judgement may play a significant role. In this case for regulated firms there are specific additional requirements
- Credit markets make extensive use of various forms of explicit Financial Guarantee contracts or implicit guarantees. Those must be reflected accurately in the adjusted ratings
- The use of credit rating systems in practice entails a degree of Human Judgement which places requirements on the guidelines and procedures in place
- ECB guide to internal models - Credit Risk, Sep 2018